IF YOU EVER find yourself with a year when you pay no income tax, don’t celebrate. Instead, rue the wasted opportunity.
Imagine it’s December, you have been out of work all year and you have almost no taxable income. Or let’s say you just retired, you haven’t yet claimed Social Security and you are looking at a year with no money owed to Uncle Sam. To take advantage of these low-income years, you might convert part of your traditional IRA to a Roth IRA, knowing the tax bill will be relatively modest. Alternatively, if you have a stock in your taxable account that you’ve been reluctant to sell because you have a large unrealized capital gain, you might seize the opportunity to unload the position.
How much should you sell? Suppose you expect to be taxed at a 22% marginal rate once you find a job or once you turn age 70½ and start taking required minimum distributions from your retirement accounts. To head off big tax bills later, you might generate enough taxable income now to get to the top of the 12% tax bracket. In 2019, that would mean total income of $103,350 if you’re married filing jointly, which would trigger a federal tax bill of $9,086. If you are single, it would take $51,675 in total income to get to the top of the 12% bracket, resulting in a $4,543 tax bill. These figures assume you take the standard deduction and all tax is paid at ordinary income tax rates.
One caveat: If you’re in your mid-60s or older, a large Roth conversion or hefty realized capital gains may boost your income sufficiently that you end up not only paying a big tax bill, but also getting charged higher premiums for Medicare Part B (doctors’ services and outpatient care) and Part D (prescription drugs). The premiums are typically based on your tax return from two years before, so 2019 premiums would be based on 2017’s tax return.
For others, generating extra income could reduce Medicaid eligibility or trim the tax credit they receive toward the cost of insurance purchased through a health care exchange. The latter can be hugely valuable—and losing the tax credit could make the effective tax rate on a Roth conversion far higher than expected.
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